It’s been a year since I last wrote about Tesla. It feels like a lifetime ago: a pandemic, lockdowns, 15% unemployment, 500K coronavirus deaths in the US, presidential election, Biden victory, democracy under attack, massive fiscal and monetary support, K-shaped recovery, stock market at or near all-time highs. For Tesla, this has been a phenomenal year with 5-to-1 stock split and more than 300% in gains. The market finally started to see the massive disruption that Tesla is about to unleash on a number of industries, which propelled the company to $600 billion market cap over the last 12 months.
So, what should we make of the recent sell-off, given this context? As rates on 10-year Treasuries rose to 1.6% in February, tech and high-growth stocks got punished.
TSLA is down 35%. Apple and Amazon are down close to 10%. Cathie Wood’s ARKK, probably the best proxy for high-growth innovation, is down 25%. To put it simply, growth stocks got punished because rates are up 60bps. Given where we are in the business cycle, I find that very short-sighted, which prompted me to comment on Twitter.
Let me elaborate. Long term rates are a measure of nominal growth expectations in the economy over the respective term. If nominal GDP is expected to rise over the next 10 years, the 10-year rate generally follows suite and vice versa. There are two sources of nominal GDP growth, real growth and inflation. Markets fear that the recent back-up in rates is due to higher inflation expectations. Since the Fed started targeting inflation in the early 1990s, the conventional wisdom has been that inflation pressures rise at the peak of the cycle. The Fed taps on the breaks and the economy slides in recession. That’s what the market fears. Growth stocks are high-risk, and that is not a good place to be at the top of the biz cycle.
What many market participants fail to recognize is that we are experiencing a paradigm shift. The Great Financial Crisis and its aftermath were game-changers. There are three important aspects to the new macro paradigm:
- The link between inflation and the output gap is tenuous at best. Pre-pandemic, we saw a dramatic fall in unemployment to levels not seen since the 1960s but without any accompanying inflation pressures. This has caused a lot of head-scratching in macroeconomic circles. More importantly, Fed Chairman Powell seems hell-bent on testing the limits of full employment. I say, Amen to that!
- Use of central bank balance sheet has become the primary tool of monetary policy. What I am talking about here is QE. The inflationistas of the 2010s were proven wrong, and they will be proven wrong once again in the 2020s. More importantly, monetary economist are also being proven wrong by the practice of central banking over the last 12 years. As Bernanke put it, QE works in practice but not in theory. Monetary policy transmits through the central bank balance sheet, and we now have central banks not afraid to flex their balance sheet muscle.
- Fiscal and monetary policy coordination. Last but not least, macroeconomists and policy makers are realizing the importance of fiscal policy, especially at ZLB (zero lower bound of interest rates). It is not a question of fiscal vs monetary policy (which, unfortunately, is how the macro debates have been framed since at least WWII). We are realizing that it is a question of coordination. With coordinated fiscal and monetary support, an economy can not only achieve ZLB-escape velocity but can also reach a state of full employment while keeping inflation at bay.
What I am trying to say here is that this is the beginning, not the peak, of the business cycle. The $1.9 trillion COVID relief fiscal package, combined with continued expansion of the Fed balance sheet, will provide a significant boost to NGDP. That’s why rates are rising. More importantly, I expect that the growth will be real with inflation remaining within the Fed tolerance level. Why? Because we are no where near full employment. There is tremendous productive capacity in the global economy, and if the demand is there, the supply will come.
Going back to Tesla. Why should you own high-risk, high-growth stock at the beginning of the cycle, even though interest rates will likely continue to rise? Two reasons.
First, you want to invest in the companies that drive the growth, not the ones that fall behind and can’t keep up (aka, the value traps). If rates rise to 3%, I’d rather be in a stock expected to grow by 50% over the next 5 years than one that may flat-line. Rather than being in a value trap, I will be better off just buying 3% bonds.
Second, as incomes rise with a growing economy, people’s tolerance for risk rises, which boosts demand for high-risk assets such as Tesla. This is a very important but rarely understood point. Stock prices are a measure of not just fundamentals but also of investor risk appetites, and those risk appetites ebb and flow with changing income expectations. That is why high-risk, high-growth stocks do so well in the upward leg of the business cycle. As investors grow more confident in their own income expectations with an improving economy, they are willing to pay more for a chance to win and charge less for a chance to lose.
My investment philosophy has evolved quite a bit over the years, and has been primarily informed by my personal struggles with risk. I believe in EMH (the efficient market hypothesis). There are no bubbles, and we all earn the risk-free rate but on a risk-adjusted basis. The reason why nominal returns vary is because people have different tolerance for risk and therefore, charge differently for risk. In other words, there are no excess returns, only excess tolerance for risk. In order to beat the market, all you need to know is your own risk tolerance: know thyself!
I think of risk tolerance in terms of a pyramid. Each step represents a slice of your wealth marked for specific needs. Money-like assets are the bottom, held as pre-cautionary savings. With respect to these savings, I have zero tolerance for risk, hence the allocation to cash. Retirement savings are in the middle. Here, I have higher risk tolerance due to the longer time horizon and the social security fall back. Therefore, I can take on more risk (stock index funds in a 401K). With every step higher, my risk tolerance rises. At the top of the pyramid, I have money I am willing to lose. This is play money I invest in companies I love (some in ROTH IRA, some in investment accounts).
Every single dollar I have invested in Tesla is a high-risk dollar I am willing to lose. I believe in Tesla and Elon. Even if the company fails, that will be alright with me because I got a chance to support the greatest innovator of our time. For a small investor, who does not trade nor has the time to keep up with the deluge of market information, you need this kind of conviction in order to pick individual stocks. Otherwise, owning individual stocks is way too risky. Most likely, you will be wrong or you will end-up exiting before you’ve realized the full upside (as I did with Apple).
I believe that Tesla can easily become $1 to $2 trillion company over the next 5 years. We are at the beginning of this expansion. We have policy makers, both at the Fed and Treasury, who are willing to test the bounds of full employment and who have the tools to keep inflation at bay. I am neither phased by 60bps increase in rates nor by inflation fears. I am staying with Tesla. That being said, I keep the bet to a manageable size I am willing to lose, and I still have the rest of the pyramid to fall back on.
